Central banks’ credibility

There is no such thing as doing something you don’t believe in to gain credibility.

The blogosphere is full of articles about why Larry Summers is worse than Janet Yellen (or was it all the way around?) and I don’t intend to add to that discussion. However, it seems to me that there is a bigger question that needs answering, i.e. central banks’ credibility.

I read today a very good summary of the arguments in favour of Larry Summers, put together by Ezra Klein (who makes it painfully clear these are NOT his views). The full article is here and I’d like to quote one paragraph:

Summers is a better dove because he’s a better hawk. (…) There are two versions of this argument. One is that Yellen will tighten prematurely, because her reputation as a dove will make it harder for her to convince the market that she really will begin tightening when the time comes, and so she’ll need to move from promising future tightening to actually tightening sooner than Summers would. Another is that investors won’t trust Yellen’s promises to tighten, and so the market will lose some confidence in the Fed and a risk premium will begin building — which would be even worse than an actual tightening.

I am very sorry to say but this is ludicrous from whatever angle you look at it. Firstly, to assume that the Governor of the mightiest central bank on the planet has to do something to convince the market she means business is a joke. Secondly, to assume that Fed Chair would at some point arrive at a conclusion that policy probably needs to be tightened in, say, 6 months’ time and then go on and tighten immediately is offensive to any sort of intelligence. And thirdly, after all these years of seemingly dollar-debasing / hyperinflationary / zerohedgey policies, can anyone argue that the market would lose confidence in the Fed?

Credibility is composed of two factors: trustworthiness and expertise.

Let’s start with the expertise. I think the cornerstone of economic analysis is the data. The Federal Reserve is the central bank that brought to you FRED and is home to some of the brightest economists out there. Working papers produced by Fed staff are of sensational quality (at least the ones I’ve read) and it’s the central bank that is embracing the modern technology in full (and I don’t mean only tweeting). True, not all of the Fed’s forecasts are spot on but they are probably accurate reflection of the prevailing state of affairs and include all available and relevant information. Additionally, the Fed has been around for almost a century. In other words, the institutional memory of the Fed really should not be questioned. And again, this does not mean they’re infallible.

So then what about trustworthiness? Do I trust Janet Yellen and Larry Summers? Not particularly, no. But it is completely irrelevant. Trustworthiness in the Federal Reserve Chairman or Chairwoman extends from the trustworthiness of the institution. That’s why markets learned to trust Alan Greenspan even if he turned out to be a true maestro of destruction. Interestingly, almost two decades of his reign, which ended in peril, did not dent the Fed’s credibility. You could think that after the mess that Alan made, the frantic printing of money would have been compounded by the disillusion with the Fed’s handling of the economy… Instead, inflation remains in check (perhaps even too much) and I don’t think people have a sense of the Fed losing control. So all in all, I think the fairy tale about the market being worried about trustworthiness of either Yellen or Summers is just that – a fairy tale. Investors will trust them both because both have their own credentials and they will be running one of the best (in terms of human capital) central banks in the world.

But as I said, I don’t want to make it all about the U.S. Do you remember November 2011? The previously modestly (or would it be moderately?) known Governor of Bank of Italy Mario Draghi became the ECB Governor. At that time it was painfully obvious that the ECB had to cut interest rates and yet for some reason people thought it wouldn’t happen during the first meeting. They were saying that it would be damaging for the ECB credibility if an Italian started his tenure in Frankfurt by cutting rates thus infuriating the Germans. Silvia Wadhwa (why does she even have the right to express her own opinions?) said on the day of the meeting she would eat her hat if Draghi cut rates. And what happened? Draghi cut interest rates and… nothing. The EUR did not fall apart, inflation did not soar, the Germans didn’t go on strike. Why is that? Firstly, because the ECB is an important player in the market that makes things happen and secondly because Draghi did the right thing. Imagine how his credibility would look like if he waited a few months just to appease the Wadhwas of the world. Would he be able to play his ace of spades several months later by saying “whatever it takes”? Perhaps but credibility is not built on appeasing investors but by doing what you think is right with support of the institution behind you.

Again, I would like to stress that what I’m discussing here is the issue of credibility rather than making no mistakes. Importantly, sometimes the market goes the other way and assumes that some institutions have limitless credibility (I addressed it in my previous post “Just do as I say, don’t do as I do“) but that’s beside the point.

I only ask you this. Don’t tell me that differentiating candidates should be based on what they may or may not do if and when the need to hike rates arises. Rest assured that they will do whatever they think is right and that it has more to do with the incoming data and the analysis coming from within the Fed. There is no such thing as doing something you don’t believe in to gain credibility (In fact, I like this sentence a lot so I will put it on the top)


3 thoughts on “Central banks’ credibility

  1. Very nice article. Yet I believe that the core issue is that economic data has to be analyzed, ergo interpreted. And here people usually disagree; people take different conclusions from the same numbers/graphs. In fact, any analysis implies a hidden opinion. And any opinion is, ultimately, built upon some kind ideology (known or unknown), personal character or living experiences. That’s why Summers and Yellen do not mean the same, because each one interpret data in a different way mainly because they two have different opinions in such an important and core issue as how monetary policy works and how it should be implemented. That’s why the economy is not like maths; indeed it is sometimes called a “social science”. The “social” part is important here.

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